I work at a small buyside shop covering corporate credit and would like to improve my modeling skills to help forecast leverage/coverage/cash flows as well as for other models relevant to fixed income (dont know if folks use default/recovery for fair value in spreads, for example). Would anyone have a book to reccomend? Any thoughts welcomed. Thanks very much in advance.
I’d appreciate this too. I have a reasonably good grip on how to go about modeling equity (this could always be improved, of course), but I’m having a harder time understanding how fixed income strategy works. Obviously part of this is trying to predict or hedge interest rate shifts, credit curve changes, and look indicators of imminent defaults, but it would be nice to have a larger framework to fit this into.
To be completely honest with you, it’s not really all that different from equity on the company level. It’s a matter of understanding the business and the nuisances of the Industry and how they flow through the financial statements. That parts the same. The divergence is once you’ve mastered how to forecast sales and cost structure, etc. you turn your attention towards the metrics that truly affect credit profiles. For example, instead of driving through all the charges looking for EPS you are more concerned with EBITDA, Cash Flow and liquidity profiles. Then you take this information to model the directionality of the credit profile, capital structure, where the Agencies will mark the credit, etc. I guess a decent example would be surrounding a product liability. An equity analyst may spend a lot of time looking for what charges the company might take whereas a FI analyst will be calculating what and when expected cash outlays will occur and if a covenant is violated. There aren’t really any books on this that come to mind. It’s really just good old fashioned experience modeling out financial statements. It’s the emphasis that’s different.
BOMC - Thanks a lot. That was my expectation to be quite frank, and that is the general direction I have been going, but could use some work. For those of us on the fixed income side who aren’t well versed in modeling out financials, and haven’t done a turn in a program at a bank, is there a resource you would suggest to help get over the hump?
Well there’s a book by Beninga on Financial Modeling that will assist you with some of the functionality needed. What kind of shop are you in? Do you have access to the sellside? A lot of them publish their models for review and they’re available for download. It will certainly assist in putting your own together. Once you understand how all those pieces come together and where actual cash comes from it will be pretty easy to do. Start digging through those 10Ks and putting the past few years of statements in a spread sheet and then try building it out a year, quarter, etc. It’s really a matter of understanding the company and how a 10% drop in XYZ filters through. And before it comes up you don’t need to drop a lot of money on WallStreet Prep or whatver if you’re just looking for 2-3 year credit profiles.
We’re small (only about $1B), and don’t have the unfettered access that some others do. I have worked off street models, but i wonder if some of the value is lost when they are so complex. Granted, they have to be ready for when some hedge fund asks esoteric questions, but 20 tabs seems excessive to me (I am simple minded sometimes, so I will save street analysts the time of telling me I am an idiot for saying that). Thanks for your advice - that is essentially what I have been doing. Its a trial and error process. I will look at that book. Thank you.
The more complex models just allow you to dig deeper into the numbers, if you don’t need to do that, they are overkill. If you have a model that can forecast out every line item of revenue, you can (probably) forecast it a bit more accurately than if you just model out total revenue growth as one item. Again though, if you’re not concerned with forecasting EPS down to the penny, you might be just fine with a simpler model.
Thank you very much, sir. That is exactly my thinking. Don’t mean to “half-ass” it, but Figuring out if a co will reduce leverage a full turn won’t really be impacted all that much by a 2% miss in sales of one of ten sources of revenue for a co only levered 2x. Yes, I would love to dig that deep, but more importantly I want to get to the correct zip code first, then fine tune. Im going about it by trying to forecast 1. Revenue 2. SG&A/COGS as % of Sales (are they reducing costs?) 3. Capex (tough) 4. Depreciation (as % of Fixed Assets, though having a bear with it) 5. Int Costs (implied from int exp/debt) 6. Debt (using maturity sched & FCF, dividends, etc) …resulting in forward leverage/coverage, etc. You guys on buy- or sell-side?
I generally think for buy side fixed income the uber-complicated models are not totally necessary. Say you are looking at a consumer staple (not my sector). One approach would be to model out each product line, looking at market share, branding, promotional initiatives, product innovations, and pricing trends to try and make detailed revenue projections. Or, you could just use expected GDP growth and add on a conservative premium if they have some higher-growth products. While the former might be more accurate (and that is a big might because of all your assumptions), it’s far from certain that the additional complexity will really help your model at all. It will, however, probably cause you to assign a higher degree of certainty to your forecasts due to the complexity of your analysis. This is natural and might even be subconscious. Of course, if you can avoid this the benefit of a detailed approach is it forces you to think closely about all the drivers. Bottom line, on the buy side we generally cover more credits than our sell side peers, so to me it only makes sense to really focus on the line items I know will move the needle on the credit. And, I’m usually pessimistic with my forecasts, as we are naturally focused on downside risks. The other stuff, like interest rate hedges, credit curves etc, is more of a portfolio management concern and isn’t usually modeled by the pure credit analysts, at least at my shop. We pay attention to the levels and curves for relative value calls obviously, but we have a quant team for modeling that stuff.
Nodge, thanks a lot. That is great color.
My shop sounds very familiar to BN’s. On the buy side you leverage the sell side for a lot of the tiny details because you just don’t have time. In other words, let them be the manager of data. When I build models, I look to the sell side to give me some guidance on expectation on the product line level. I pick it up at the segment level and build from there. For example, I cover Big Pharma and even though I need to know what products in the Animal Health division of Wyeth are doing, I don’t have the time to model that out in 2011. All I need to know is the patent expiration and what the directionality is, etc.
I had a FI friend explain to me that FI at the company level is much more about understanding the tail risks. Basically, if you have enough EBIT, you are likely to get your coupon payments. If you have enough EBITDA, you are likely to be able to sustain payments without running down the business. After that, all you really want to know is that EPS will continue to be larger than zero, so it’s not as important to predict it down to the penny as in equity (though some will argue that trying to predict EPS to the penny is a waste of time even in equity). So the big questions have to do with relatively low probability events that can have a substantial impact on short and/or long term ability to pay principal and interest. Those low probability events are on the tails of distributions, and tails are difficult to measure precisely. I’m more curious about some of the other aspects to FI portfolio management, such as how to think about yield curve changes, credit curve changes, and how to construct optimal portfolios given a set of views. Is there a good book for that?
Just curious For FI models, do analyst usually just forecast out EBIT and EBITDA (which at times not a good representation of cashflow) to get an rough idea of debt coverage, or do they go into details and forecast out the exact cashflow availiable for debt servicing (more difficult with Capex and WC involved).
Zuran, I have been trying to do both of those, which has led me to start this thread. Its pretty difficult for someone without formal training, but I am working on it. I try to work in equity buybacks, dividends, wc, capex, etc. In all honesty, with that many variables, I am sure i am getting less accurate rather than more so, only due to the fact that there are more variables to mess up! Chadwick, The management side is more what I am familiar with, and I can tell you (you will hate this), but Fabozzi is really the bible on this. I was given a copy my first year in the business by someone who was not in CFA program, so he wasnt even biased by the curriculum. He gives it to all his new folks. There may be more, but his stuff is kind of the standard as far as I know.
I have read a number of Fabozzi books and I like them a lot. Fabozzi does a good job of giving you the high level view on things. I spent yesterday reading the last chapter of fixed-income securities, which talks about fixed income strategy. Fabozzi doesn’t always get very deep into the math details, but he doesn’t go completely qualitative, and he points out some issues that pop up even in preliminary mathematical formulations. In short, I’m a Fabozzi convert, despite my innate suspicion of publishing machines like his series.
Yeah Fabozzi is the standard. Everyone here gets a copy of the handbook when they start, and you see it sitting on pretty much all of our PMs desks. Mine sits at home on my bedside table, how sad is that!
Which fabozzi books are most commonly used?